Some Glide Paths Can Trigger Bad Bond Buying

December 2, 2013 (PLANSPONSOR.com) – Accounting for the source of funded ratio increases within defined benefit (DB) plans is critical for preventing imprudent fixed-income purchases, new research shows.

The research, published in a short white paper by Towers Watson, suggests certain static asset-allocation strategies adopted to reduce risk in DB plans through the introduction of liability-hedging assets can trigger inappropriate bond purchases.

Specifically, researchers take issue with allocation glide paths that specify the amount of assets to be placed into liability-hedging investments each time a DB plan’s funded ratio increases beyond a given target—regardless of what actually caused the funded ratio increase.

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For example, every time a pension’s funded ratio improves by 10%, it would trigger a predetermined amount of assets to be moved away from equities and into fixed-income products, which are generally considered less risky and can reduce future funding ratio volatility.  

Under this setup, researchers argue, it is possible for strong equity returns to trigger imprudent bond buying. That’s because this type of allocation is built on the implicit assumption that the increase in the DB plan’s funded ratio would be caused by a rise in interest rates and a subsequent fall in liabilities. This result would suggest increasing exposure to the fixed-income market under a more favorable yield environment, protecting returns while also limiting volatility.

Instead, researchers argue, what DB plans more often see is a spike in funded ratios due to growing plan contributions and stronger return-seeking asset performance. As a result, plan sponsors are in a position where their static glide paths suggest moving into bonds at a time when interest rates may still be historically low, and fixed-income assets are therefore perceived to be trading above fair-value levels.

Researchers argue this all leads to one conclusion: The source of funded ratio improvement matters when it comes to adjusting asset allocations and should be programmed into a more dynamic asset-allocation strategy.

Dynamic asset allocations have two primary benefits from a plan performance perspective, researchers say. The first is to better preserve a favorable funded status once it is attained regardless of whether the source of funded ratio improvement is contributions, equity performance or shifts in interest rates.

The other benefit is the potential to capitalize on yield-curve movements by purchasing bonds at a time when fixed income is more favorably priced. For corporate pension plans, researchers argue this goal is only satisfied when the funded ratio grows as a result of rising corporate bond yields and falling liabilities.

Given that there are two benefits to moving into fixed income when funded ratio improvement is sourced from rising interest rates, researchers argue there is a stronger incentive to add bonds in this case than when funded status improves solely due to contributions or strong equity returns.

Researchers go on to suggest a two-pronged approach to asset allocations, where the speed of asset-allocation movements from equities into bonds depends on why funded status improves. For example, a standard glide path may increase bonds 8% for every funded ratio trigger reached. But a more efficient, dynamic approach would increase bonds by 12% every time the funded ratio improved due to interest rates rising and 4% due to contributions or strong equity performance.

More results from the research and associated white paper, dubbed “Dynamic Asset Allocation for Defined Benefit Plans / Dynamic Investment Strategy 2.0,” is available here.

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